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Europe’s green upgrade could require more than €300bn capex debt

Alternative lenders will take the lead in financing the retrofitting of Europe’s commercial real estate stock, the manager argues.

More than €300 billion of debt finance could be required to fund the capital expenditure needed to ensure Europe’s commercial real estate stock meets environmental standards in the coming years, CBRE Investment Management has told PDI‘s affiliate title, Real Estate Capital Europe.

In a new research paper shared with Real Estate Capital EuropeThe role of credit in transforming European real estate to meet future ESG standards – the manager argues alternative lenders, of which it is one, are better positioned than banks to provide the huge amounts of debt needed to retrofit Europe’s real estate.

The report’s author, Dominic Smith, who leads credit research in CBREIM’s insights and intelligence team, explained that refurbishment, rather than wholesale redevelopment, will be the most efficient option for many building owners. He described the sustainability-focused upgrade of Europe’s stock as a “significant one-off event”, rather than a regular maintenance exercise.

Smith’s team estimated that should, either legally or through occupier choice, an Energy Performance Certificate B standard become a minimum requirement by 2030, 60 to 75 percent of commercial stock could require refurbishment to meet that standard. Estimating Europe’s commercial real estate debt pile to be around €1.2 trillion, the team suggested assets against which €720 billion to €900 billion of debt is secured will require refurbishment.

It went on to estimate how much of the overall refinancing amount will need to be ringfenced specifically for capex. Of the circa €10 billion of financing requests CBREIM received in 2021, those with a sustainability-refurbishment aspect required capex financing equivalent, on average, to 22 percent of asset value and 35 percent of the total loan amount.

On that basis, the company estimates between €252 billion and €315 billion of the debt needed to refinance this real estate will need to be set aside to fund capex.

Non-bank opportunity

Emma Huepfl, managing director and co-head of EMEA credit strategies at CBREIM, told Real Estate Capital Europe banks are increasingly focused on financing core property, meaning alternative lenders are more likely to provide finance for significant capex projects. “Alternative lenders are better positioned to structure loans around business plans,” she explained. “Banks will be suited to providing take-out finance for these assets, post-renovation, and alternative lenders which take on the transitional financing risk will typically be expecting a bank refinancing exit.”

Smith added: “There is a significant funding gap for this type of finance, so institutional capital should flow in that direction.”

As sponsor demand for capex finance rises, alternative debt providers stand to earn attractive risk-adjusted returns, Smith argued. “From the sample of financing requests that we received in 2021 which featured an ESG retrofitting aspect, we saw a margins of 400-500 basis points on offer, which translates to a total return of more than 7 percent. That’s some way ahead of consensus forecasts for returns on ungeared real estate equity investments over the next few years.”

But Huepfl argued cautious underwriting will be critical for lenders to ensure refurbishment financing risk is managed. “In a capex-heavy project, it is important to have equity investment and development experience in your platform because there’s a higher risk things may not go to plan in such projects, including due to cost inflation and rising rates.

“Sponsors are also refurbishing into a market which is structurally changing and where demand is unpredictable. So, as a lender, you need to ensure your investment will translate into value-protection.”

Obsolescence risk

Stock picking of successful refurbishment projects will be critical to alternative lenders as they seek financing opportunities in a market where the risk of properties becoming obsolete is high. “There is a hidden problem on lending books and a risk to equity that has not been fully priced into the market,” Huepfl explained.

She said that while the market will generate opportunities for lenders to finance successful upgrade projects, building owners seeking finance for upgrades which fail to add sufficient value to properties in fringe locations, or where the use of the asset is unsuited to market trends, may find they encounter less debt liquidity.

Smith added that rising construction costs will disproportionately impact more marginal refurbishment schemes.

“As occupiers seek only those EPC B minimum standard buildings, there is the possibility for an unintended consequence of assets becoming obsolete,” he said. “This needs to be considered now and it could require local authority and central government help to ensure assets that may not be economically viable for lenders and sponsors to retrofit have a future.”